How much capital should banks hold to cover their risk? This column argues that the preoccupation with capital rules misses a more fundamental concern. No amount of feasible regulatory capital can be an appropriate substitute for robust asset selection and valuation standards of banks.

How much capital should banks hold to cover their risk? That question has been thrown back and forth among policymakers, bankers, and academics for years – and now, with the global crisis still lingering, the debate is more intense than ever.

The official sector – through the Basel Committee on Banking Supervision – have set the minimum Basel III capital adequacy ratio (CAR) at 10.5% , but have yet to reach an agreement on the magnitude of a proposed capital surcharge for so-called “global, systemically important banks”. Bankers, on the other hand, have argued that an overly conservative minimum CAR is too costly and will negatively impact credit intermediation and jeopardize the economic recovery. Finally, prominent academics, led by Anat Admati of Stanford, have made a strong case to increase the minimum CAR to 15% (based on a non-risk weighted assets measure), arguing that the industry’s concerns are nothing more than scare-mongering and that the new Basel III capital rules fall far short of what is needed to lessen both the likelihood or severity of future financial crises.

There is no doubt that strengthening both the quality and quantity of bank capital should make the global banking system better able to absorb and provide more tangible buffers to curb, excessive risk-taking at individual banks. Against this background, it is hard to argue against the need to maintain even higher than the minimum Basel III capital requirements, particularly for systemically important banks. Nevertheless, the current preoccupation with capital rules misses perhaps a more fundamental concern: that no amount of feasible regulatory capital can be an appropriate substitute for robust asset selection and valuation standards of banks, both of which are reliant on strong risk management (banks) and supervision (authorities).

Capital is a residual. It is the difference between the value of bank assets and liabilities. Because most bank liabilities – in general- are carried at cost, capital is heavily influenced by a bank’s asset selection criteria (origination standards); and second, the reliability of ongoing asset valuations, particularly impairment on loans and securities not held for trading, and “hard-to-value” assets carried in the trading book, where quoted market prices are not available. Herein lies the challenge. Both the quality of origination standards and price “discovery” for a substantial portion of bank assets, remains more art than science; and it is wholly reliant on the exercise of sound judgment –supported by critical analysis – by bank risk managers and bank supervisors. These qualitative factors cannot be appropriately addressed by simply increasing the minimum CAR.

The implications of poor asset selection standards and wrong valuation judgments are anything but inconsequential, as a small change in asset values can have a disproportionate impact on the reported CAR. Consider that a 5% drop in asset values approximates a 48% decline in the minimum Basel III capital requirement, if capital is measured as a percentage of total assets. Even an increase in the minimum CAR to 15% will not materially alter this relationship.

Given the clear linkages between the reliability of reported capital and the quality of risk management and supervision, key stakeholders should focus on the far more difficult challenge of “how to” strengthen risk governance and supervision.

As a starting point, policymakers may need to revisit how prudential rules that govern bank compensations systems, asset origination, risk management, and asset valuation practices are written, so that these rules provide a better balance between explicit standards and broad principles, in order to introduce more “constrained discretion” in day-to-day risk management and supervision.

Second, authorities will need to refocus efforts in training its front-line supervisors, in order to ensure that they are equipped with the knowledge, skills, and abilities to serve as a formidable line of defence against excessive risk taking at both individual banks and the banking system as a whole. For its part, bankers must ensure that its incentive structure does not promote excessive risk taking; and that it provides sufficient resources to, and elevates the stature, independence, and authority of the risk management function, so that they are willing and able to say “no” in response to a degradation of asset selection standards and imprudent asset valuation practices.

Third, key market watchdogs – such as rating agencies, analysts, and institutional investors- must take a more nuanced approach to interpreting and evaluating the CAR, so that they can provide true meaning to the often used – but rarely effective- concept of market discipline.

The recent financial crisis is a humbling wake-up call. The capital adequacy ratio is meant to mitigate crises, but has on too many occasions served to mask the true health of numerous banking organisations and national banking systems. Without a better understanding of – and greater focus on – how risk management and supervision interact with bank capital, the new Basel III capital rules may prove to be nothing more than “fool’s gold”.

The views expressed are the author’s own and should not be attributed to the IMF or Bank Indonesia.